(January 14, 2013) – The brain operates on a principle that ought to be familiar to all asset owners and managers: resources are scarce.
The crossover applications between neurology and economics don’t end there. In fact, an entire discipline has sprung up in their midst: neuroeconomics. Two leaders in this field have teamed up and crafted a list of the eight crucial takeaways from neuroeconomics for money managers.
According to Paul Zak, the head of a center for neuroeconomics at Claremont Graduate University, and Steven Sapra, a finance professor the University of Southern California, these are the key points of neuroeconomics for money managers:
1. Anticipating Rewards: Acquiring money and anticipating it have a similar effect on the brain as winning a hand of poker or eating when hungry. This “rush” wears off over time, however, and thus we are biologically driven to seek novelty. Excessive risk taking is more likely when an investor has had several recent successes that push the wanting system seek greater and greater rewards. For this reason, managers should monitor indicators of daily trading volume to prevent excessive trading.
2. Balancing Risk: Since brains “feel” risk the same way, whether it’s riding a roller coaster (safe) or veering off the road in a car (decidedly unsafe), experience is essential to modulate emotional responses to risk. Traders can become over-accustomed to high risk activity, or not take enough risk in highly trending markets. This is another area where monitoring systems can be helpful.
3. Wait for It: Delaying gratification is difficult and tiring for the brain. When markets are volatile, investors’ self-control systems are heavily taxed. This is precisely the situation in which an investor is more likely to make decisions based on immediate gratification and little deliberation, rather than on the basis of the bigger, later payoff. In a volatile-market situation, making no decision is preferable to making a poor decision.
4. Following the Herd: Human beings are social animals. We’ve evolved to learn from one another, but also to follow the crowd. Desperate buying and panic selling are the inevitable consequences of herd mentality. Investment professionals should keep this bias towards common action in mind when deciding if an asset’s well-priced or simply in vogue.
5. The New New Thing: Going back to Lesson One, the brain responds to novelty almost as it responds to rewards like money or sex—and this applies to information as well. It is important and difficult to keep newness and success cognitively separate. Try to minimize the amount of new information flowing into the brain, so you’re better able to judge its quality.
6. Checking References: The brain makes decisions based largely on reference points, or baselines. For example, several studies have shown that after a gain, people take on more risk:
The brain’s reward system is cranked up and wants more. Similarly, after losses, many people increase their risk exposure to get back to their break-even reference point. This is, of course, not always the best condition for sound judgment. Investment professionals should try to analyze investments on their merits alone and ignore the path they took to get where they are today.
7. Rational Rationality: Brain circuits that are repeatedly used develop a bias to activate when they encounter the same or similar stimuli. The brain saves energy by performing repetitive tasks—like showering or driving—without devoting conscious awareness to them. To avoid becoming lazy-brained and investing based on unconsciousness and repetitive processes, bring in some form of novelty: change offices, talk a walk, put on music, or go on vacation.
8. Portfolio Love: The circuits that make us grow attached to our families, pets, and homes also operate on our portfolios. If we are around anyone or anything long enough, we develop either
an aversion or an attachment to him/her/it. This attachment behavior is part of the evolution of humans as highly social creatures. As a result, we value what we own more than what we do not, which is something researchers call the “endowment effect.” Be aware of this process: you might, at some level, love your portfolio—even if it does not love you back.
To read Zak and Sapra’s whole article, “Eight Lessons from Neuroeconomics for Money Managers,” click here.